Question

This problem is appeared already in Financial Accounting book

But, It is slightly different from the problem in the book (Ex. Not LIFO But Weighted average cost)

So, I can't refer to answer in the book part.

BTN 6-3 BTN 6-3 Golf Mart is a retail sports store carrying golf apparel and equipment. The store is at the end of its second year of operation and is struggling. A major problem is that its cost of inventory has continually increased in the past two years. In the first year of operations, the store assigned inventory costs using weighted average cost. A loan agreement the store has with its bank, its prime source of financing, requires the store to maintain a certain profit margin and current ratio. The store's owner is currently looking over Golf Mart's preliminary financial statements for its second year. The numbers are not favorable. The only way the store can meet the required financial ratios agreed on with the bank is to change from weighted average cost to FIFO. The owner recalculates ending inventory using FIFO and submits those numbers and statements to the loan officer at the bank for the required bank review. The owner thankfully reflects on the available latitude in choosing the inventory costing method. Required 1. How does Golf Mart's use of FIFO improve its net profit margin and current ratio? 2. Is the action by Golf Mart's owner ethical? Explain.

Answer 1

1. A shift to FIFO from weighted average costing will lead to the cost being accounted at the earlier prices which were lesser. This will result in the cost of goods sold having a value lower than the weighted average cost and subsequently show higher gross profit and net profit. Also, in FIFO the ending inventory reflects the most recent prices of inventory; thereby inflating the figures. A higher inventory value will increase the current ratio due to the numerator of current assets being overvalued.

2. It is certainly unethical to show inaccurate figures in the financials just to obtain a bank loan. This may get him the bank loan eventually but the payments will be a problem to due liquidity issues due to incorrect accounting. Also, the same will discovered during audit sooner or later and will put the owner in to trouble due to inconsistent financial reporting. The owner must understand that the flexibility of choosing inventory methods must be only applied if the method will result in better presentation of financials or as required by law.